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KGB INTERROGATION: Donald McGauchie

Telstra chairman Donald McGauchie explains why structural separation is a bad idea for Australian telecommunications, what would stop him bidding to build a fibre-to-the-node network, and how he'll get by without Sol.

AK: Donald McGauchie, thanks for speaking with us. Paul O’Sullivan of Optus was quite critical of Telstra’s behaviour this week. What’s your reaction to what he said?

DM: Oh look, I’m not particularly interested in what other people have to say. What we’re interested in is doing our own thing and we’re obviously looking at how we respond to the Government’s requests and we’re in the process of considering that right now.

AK: One thing that he is calling for, and other people are as well, is that the structural separation of some sort is made a condition of winning the fibre-to-the-node network tender. The Singapore Government has done that – they’ve made that a condition – and SingTel supported that process in Singapore. So what’s wrong with it? Why shouldn’t that be made a condition of the tender?

DM: Look, a structural separation is frankly really dangerous in terms of what it does to a system. There are no examples anywhere of where structural separation has been effective and indeed there are plenty of examples where a structural separation was tried – the US is the best example of that where the effect is serious damage to any future investment in the network and the system.

This is a dynamic system that needs constantly investing in and upgrading and frankly I think if that was done, not only would it be unattractive to us, but it would be incredibly damaging to Australia. There are no examples where this has worked and I think if I look at it as an Australian more so than even a Telstra position, all I can say is that it would just be so damaging to future investment in the network. We would do the same damage to this industry that has been done to the coal industry by fragmentation of ownership and over-regulation.

AK: So would you refuse to bid if that was made a condition?

DM: Yes.

SB: Donald do you have the same view about operational separation?

DM: Pretty much. I mean operational separation is a continuum from relatively mild and not too intrusive through to something that is very intrusive like you’ve got with BT in the UK. So we can live with some level of operational separation, but it has to be in a form that does not impede our capacity to operate the system and, more importantly, impede our capacity to invest in the system.

RG: Donald, if you had your way, how would you like this fibre-to-the-node contract to be organised, mindful of the Government money coming in and the pricing of the end product. What do you really want?

DM: [laughs] Look, this is an issue for the Government and I guess making comments around that at this stage is probably not going to be terribly helpful. The Government has decided to go down a particular path and we will do our best to work within that as long as it makes some sense for us. I’ve got some fairly strong views about the whole process but the Government has taken a particular position. They’re going down that path and we’ll work with that.

AK: But you've had a few wins lately and there seems to be growing general view that Telstra’s the only viable bidder and the only viable winner. Do you feel that way?

DM: Well look, you know, we have got the capacity. We’ve got the technical capacity. We’ve got the existing network and we’ve got the financial capacity to deliver what’s required for this country in a very short space of time. No one else can do it in the way that we are capable of doing it and producing an outcome for the country.

I think we have seen what happens when people who are not capable of doing something are given a free kick and an opportunity to do something that they’re not up to and you’ve only got to look at what happened with the Opel process to realise, even on a relatively small scale, that even with a very large free kick other people were not capable of delivering something that they had contracted to do.

So when you start talking about what is a $10 to 12 billion investment, to do what the Government hopes to do you really have to look at that capability and I can’t imagine that the Government would want to go down a path with someone who was not capable of delivering.

You know, had the previous Government still been in power, and looking at the decision that they made with respect to Opel...the embarrassment that that would have caused would have been bad enough. But if you actually lock the important and real investment that we need in fibre-to-the-node into the same sort of process, the outcome for the country would have been dreadful.

SB: Donald, the Government’s putting up $4.7 billion for the fibre-to-the-node network. Is it non negotiable that Telstra fully own a fibre-to-the-node network?

DM: Look they’ve been fairly clear in saying that they’re open to looking at the various ways in which that investment could be made and they don’t have, as I understand it, they don’t have a fixed position. They’re open to suggestions about how best to get the outcome that they’re looking for and that outcome, if you distil it, is how do we extend what is commercially viable to the 98 per cent of the population that they want to get this network to, and as I understand their position, you know, they’re open to proposals that make sense.

SB: But what about your position. Is it fixed?

DM: Look we hold a very strong view that we need to control this system end-to-end and be the ones that make the decision about how it’s operated and how future investment is put into it, so anything that makes that difficult, that turns this industry into something that looks more like the coal industry and less like the iron ore industry is not something that we would find attractive.

AK: And do you need their money? The $4.7 billion?

DM: Look, there is a big lump of this proposal which is commercially viable, where you’ve already scoped that out. We know what we are capable of doing and it’s capable of producing a reasonable return. Beyond the edges of that, if the same kind of standard is to be put in with a national interest perspective, then clearly it does require some additional investment that’s on a non-commercial basis.

RG: Donald if you get a satisfactory contract, whatever that might be, how will this transform Telstra and over what period?

DM: I think it has the capacity to do to the fixed line system what we’ve done to the radio system and that is to bring the technology up to world standard – what we did with Next G, and I think only now are a few people, and not many yet, fully understanding what we’ve done with that Next G network.

There’s far too much controversy about shutting down the old CDMA network and coverage and other things at the margins and not enough understanding that we have got the best radio network in the world right now, if you take both size and speed into account. We cover 99 per cent of the population with a system capable of delivering 14.4 megabits to them right now, even though there aren’t the devices for handling that yet, but they’ll be around pretty soon and we’ll take that system to 21 megabits this calendar year and we’ll take it to 42 megabits next calendar year. That is an astonishing performance from any system and we’ve delivered that commercially.

What we would like to be able to do is to do something similar with the fixed line system. If you look at the cable network, the HFC [hybrid fibre-coaxial] network, we’ve now got that running at 30 megabits plus, to 1.85 million homes. So where we’ve been allowed, or should I say not discouraged from making commercial investments to really drive performance in the network, we’re out there doing it with our ears laid back.

And we would like to bring the fixed line network up to not just international standard, but right to the forefront of international standards – so it would give us an HFC network which is very good by world standards. A radio network which is pretty much the best by world standards and a fixed line network which is right up there by world standards, which is what we need as a company and what the country needs.

AK: But it will re-establish Telstra’s fixed line monopoly, will it not?

DM: NO.

It’s an open access network, so we have never said other than we would provide access to our competitors on that network and remember that our major competitor has got an HFC cable network out there that they refuse to invest in. They refuse to use it because they want to piggyback off our system and cause us to make the investment. We do not hold a monopoly when two thirds of the phone services in Australia today are mobile. More than half of those are held by our competitors and there is an HFC network out there which is capable of being a competitor to us. So it is not a monopoly position and putting this system in place would not put us in a monopoly position.

RG: You’re planning a $10-12 billion dollar project, in which, of course, some money has come from the Government. That’s going to hit your cash flow after 2010. Will this affect the dividend or how will this affect the company?

DG: We put out some projections at the end of 2005 as to where we saw the company going and how the returns would play out from those investments. One of the sad parts about what was happening here before we made the big changes two-and-a-half years ago, nearly three years ago now, was that this business was being run down. It was not being invested in. There was a lot of investment going in, but it was all patch up. We had to take some big decisions about the long term investment in the business and we put out the projections around that, that took into account the capital required and indeed took into account the possibility of a fibre-to-the-node investment. I think you’ll all remember the famous asterisk that appeared in the original, so you know, the numbers will change if we do make this big investment.

There are some positive sides to it for us and very significant positive sides. And certainly the scale of the capital investment that we require will go on a little longer than it would if we weren’t doing fibre-to-the-node, but the other positives that come from that, if we can do this in a way which is commercially sensible, will enable us to run the business in a way which is satisfactory to the shareholder. So if you go back and look at the numbers that we put out earlier on, we’ve obviously upgraded those a little, but you can see what it does to cash flow and returns and our ability to fund dividends either with or without it.

RG: Donald, going back, effectively the board has been in a 'capital strike' in areas where returns were regulated and where there were Government restrictions. Not overall of course, but in those areas. Do you agree with that statement and will that continue into the foreseeable future?

DM: [laughs] Look, I find the use of the word 'strike' fascinating. I mean every business, every board and every management team sits down every year and looks at investment opportunities and you make a decision – do you invest or don’t you invest according to the returns and the risk and you balance those things out.

Now, those are the decisions we make. We don’t make decisions about 'strikes'. What we do is decide do we or don’t we invest according to the returns and the risks that are associated with those.

This industry has got some huge risks. It’s got technology risks. It’s got the normal business implementation risks and it's got regulatory risk. Probably more regulatory risk than pretty much any other industry I can think of, but let’s not get into a debate about that. It just has big regulatory risks and so we balance out every time we make a decision on a big investment or a small investment how those things play out, and we decide 'go' or 'no go' on the basis of that. Not on the basis of a strike – we just make the decisions on the basis of returns.

RG: The Government officials use the word 'strike', by the way.

SB: Donald, you said that if you don’t get to build the fibre-to-the-node network you can spend the capital elsewhere. Now once you get through the transformation programme, what are the growth options with or without the fibre-to-the-node?

DM: Depending on how this plays out and the way things work out there are various ways in which we can look at how we will invest shareholders’ money. If there are no reasonable opportunities, you return the money to the shareholders and let them go do something else with it. So it’s not just a matter of investing it elsewhere – it’s a matter of where you can get the best return for the money that shareholders have entrusted to you.

Now, as you’ve seen over the last three years, because we have been restricted in the way in which we could invest in the fixed line network, we’ve invested heavily in the cable network and we’ve invested heavily in the radio network and we’ve looked at some opportunities elsewhere in the marketplace. Depending on what happens with the fibre-to-the-node, we'll look at the opportunities are we’ll make those decisions by looking at the circumstances as they arise.

SB: I think you, or it might have been Sol Trujillo, have indicated that you would look at investment offshore?

DM: We are looking at offshore opportunities regardless and, as you’ve seen, we’ve made an investment in SouFun [SouFun.com] in China which has proven to be a very successful one and we would hope that we can expand those sort of opportunities. We’re looking at those and course we’re always scanning the horizon for even bigger opportunities. But you know, it’s not overall. We’ve got the capacity in our balance sheet to do fibre-to-the-node and to make some significant investments if the right opportunities present themselves, but not only if the right opportunities present themselves.

RG: Donald how do you contrast Steven Conroy and Helen Coonan?

DM: Look we deal with whoever is the Minister on the day and I don’t think you can necessarily look at an individual minister. I think you’d have to look at the people around them and the people behind them and the Government as a whole.

RG: Well, then how do you contrast the two governments?

DM: I don’t think there’s any real value in getting into that discussion. The present Government, the new Government has a view as to what they want out of telecommunications and we’ll do our very best to work with that.

SB: Donald, Sol Trujillo recently indicated to a business magazine that he’d probably leave Telstra in 2010 when the transformation is completed. Is that your understanding and have you started planning not just the Sol successor, but for the possibility that the team he brought with him may also depart?

DM: One of the first discussions I had with Sol was around succession. I think we had done a very, very poor job of succession in Telstra in the past and so succession is something that is at the top of my list all the time.

Succession will depend on a whole raft of things. Frankly it all depends on heartbeat. It depends on keeping out of the road of buses and it...can depend on what the business is doing and where it’s going, so we just monitor that on an ongoing basis. There are no decisions, fixed or otherwise, made about where we’re at.

We’ve invested an enormous amount of money in this company in our senior team. Certainly there are some people that Sol brought in with him who we knew very well, right from the day they arrived, were not going to be here for a long period of time. They were not going to make Australia home. On the other hand, we’ve recruited and internally promoted people who are going to be here for the long term and so as we’ve got things to tell the market we’ll tell the market. Certainly from the point of view of board and my position, you know, that's right at the top of the list of considerations.

AK: But Sol does appear to have made a decision to go in 2010, so don’t you have a responsibility to ensure that there’s a proper succession?

DM: I don’t know exactly what Sol said, but let me tell you the discussion that I’ve had with Sol and what I’ve told the marketplace, and that is that when Sol came here we talked about the period that he would come for. We discussed periods between three and five years and if you look at the way we set things up we were aiming at about a four year period, but there’s nothing fixed about that. That could change in terms of it being longer if the circumstances were right.

SB: So are you saying that there’s a chance that Sol may go within 12 months?

DM: NO. No I’m not saying that. He has said that he’s committed to seeing the transformation through and he will certainly do that. How much longer after that he stays or what we do will depend on the circumstances at the time.

SB: Do you have preference or an internal or external successor?

DM: I always have a preference for an internal successor. I think that’s the best way for any organisation to go, but you’ve got to have the right people.

SB: Will Telstra require a different style of leadership post-Sol?

DM: I’m not sure how I would describe Sol’s leadership. He’s an incredibly able international-standard business-person and that’s what we need for Telstra. So in terms of someone who is utterly focused on the business, who really knows the business, and has a very good understanding of the business right across the world, that’s the style of leadership I want. It’s what we’ve got with Sol and I’d expect it as we go forward.

AK: But do you think you’ll need somebody who is more inclined to be a wholesaler?

DM: [Laughs] NO!

SB: Or less combative?

DM: Oh Sol’s not combative. But he’s very direct. And he has got a very clear idea of how you should make judgements in relation to the investment of shareholders’ funds. That’s what I would expect from any chief executive.

SB: Donald at last year’s annual meeting the shareholders voted against adoption of the remuneration report. In March, about six months ahead of schedule, you issued an update on this year’s long-term incentive plan. How should we interpret that and have you engaged with the institutional shareholders and the proxy advisers?

DM: What I said to the shareholders right throughout last year, and what we’ve continued to do, is consistent with a pattern that we’ve operated and continue to operate – that is, we’ll engage with the shareholders when we’ve got something firm to tell them.

We’ve got a lot of elements of last year’s programme that were known well in advance. Other elements took us longer to get in place than we would have liked, but as soon as we had them in place we announced them to the market. We always knew that last year’s programme was going to be a very complex programme and difficult for people to understand and that carried with it a risk.

That risk materialised in the vote that we had at the end of last year. We always said that we would move to a more simple system over time. That programme was put in place to support the transition of the company – the transformation of the company.

That’s exactly what it was – it was set up for that purpose and we said we would return to 'a more normal type of long term remuneration programme’ as the transformation worked its way through. That’s exactly what we’ve done. Since I've been chairman I have engaged with our major shareholders as often as I thought was suitable and have always been available for them to talk to me when they wanted to. I think while there’s been a change, it’s been a change which is part of what we’ve always done and exactly what I flagged we would be doing.

SB: And were you chastened by that vote? And are you more inclined to be conciliatory this time around?

DM: [laughs] Look, nobody likes a vote like that and I think we learned some important lessons from it. I wasn’t overly surprised by it. We were always concerned that a very, very complex remuneration plan of the sort that we were putting forward would have its difficulties. It happened in an environment where a little too much consideration is given to ticking the boxes rather than the full understanding of what we were doing and how we set out to achieve that – and the way that that was set up to drive the transformation.

That was something that was always a risk. We understood that. We talked about that a lot internally. We tried to do as much as we could to mitigate that misunderstanding, but we knew that what we were doing was the right programme. We engaged with the shareholders. We will continue to engage with the shareholders and very much take into consideration their views and their interests.

AK: Donald, thanks for the interview – thanks very much for joining us.

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